The Past Performance Game: Don’t Play It

Play this game instead

Recently, I wrote an article in which I presented a “mystery” set of investments and had you choose the one that looked the best to you. I will not give away the punchline, in case you have not yet read it. That piece proved to be popular among Forbes.com readers. So here, I present a different game of sorts. My hope is that by playing this game for the next couple of minutes, you will refrain from a dangerous yet extremely popular game that has regrettably stood the test of time…investing based primarily on past performance.

It doesn’t matter how many people like me write about that subject. Because the truth is, so much of Wall Street is focused on pumping the idea that what you just missed out on is what you should want right now. It is impossible to not get at least a little tempted. Don’t.

That does not mean that an investment that did well in the past will not do well in the future. But it also doesn’t mean that an investment will do well in the future BECAUSE it did well in the past, especially the recent past. Now, on to today’s game…

In each of the next four pictures, you will see the same two indexes compared. One tracks growth stocks, and the other “defensive” stocks. Each is a subset of the Russell 1000 Index, which tracks the 1000 largest U.S. stocks. Simply ask yourself, which one would I buy? If you are like many investors, you will skip all of the boring statistical, cyclical and investment environment factors and focus on one statistic in particular: which one did better recently?

As you can see, Growth stocks roared through the late 1990s. Defensive stocks did well too, but not as well.

Then, the dot-com bubble went bust. Stocks in general went down, but defensive stocks held in much better on the way down, and thus had much less ground to make up later. So, at this point in the game, are you thinking that the Defensives are the better choice for the next few years? Perhaps today, reading this article, you would say that you’d buy the weaker recent performer (Growth). But back then, watching your monthly investment statement go “boom,” you might have sworn off stocks altogether.

As it turns out, both types of stocks recovered from 2004-2007. But would you have stayed steady when Growth stocks hinted at a comeback in 2004, then dropped again later that year before finally bottoming?

Finally, just when you thought it was safe to go back in the water, 2008 happens. Bad turns to worse and worse turns to near-collapse of the financial system. And it didn’t matter what you owned, what it was called, or how much you screamed at your investment statement, it was unrelenting for a while.

This quick trip down stock market memory lane reminds us that investing is not guessing, and it is not simply about “staying with it for the long term.” But one thing you can do to tip the balance into your favor a bit is to avoid some of the most damaging investment habits. Investing with a strong bias toward past performance is one of them.